The family limited partnership (FLP) is a popular method for shifting wealth from one generation to another. Because of its misuse, however, the IRS has attacked the FLP, sometimes with successful results.
But before you categorize the FLP as an aggressive and illegal tax shelter, it’s important to understand that the IRS won in tax court only when taxpayers treated the FLP as an extension of themselves and used the partnership’s assets as their own.
If properly administered, the FLP remains a very useful planning tool. By reviewing recent tax court cases involving FLPs we can learn how to use an FLP correctly in estate planning.
But first, let’s clearly define our terms. What is a family limited partnership, anyway? A partnership is “an association of two or more persons to carry on, as co-owners, a business for profit.” To be treated as bona fide by the IRS, a partnership must have a substantive business purpose and observe partnership formalities. There are two types of partnerships: the general partnership and the limited partnership.
In a general partnership, there is no firewall between the partnership’s activities and the partners. In other words, partners are personally responsible for the business’s liabilities. In a limited partnership, there is at least one general partner and one limited partner. The general partner acts as the business’s manager and acts on behalf of all the other owners. The limited partner is a passive investor. While the general partner is personally liable for the debt of the partnership, the limited partner can only lose the assets he or she contributed.
In an FLP, the parents or grandparents create and transfer personally owned assets to the business. Typically, the FLP is funded with real estate, stock in a family-owned corporation, or publicly traded securities. Over time, the older generation will give or sell limited partnership units to the children or grandchildren. The goal is to reduce the older generation’s ownership to between 1% and 25% of the FLP.
The FLP is attractive because it provides an opportunity to substantially reduce gift taxes and the taxable estate through valuation discounts, while allowing the donors to retain some control over the partnership’s assets. As general partner, the older generation can transfer their wealth and, at the same time, manage and make all investment decisions for the younger generation.
Valuation discounts allow the estate owner to give away more tax-free using an FLP than by giving the underlying assets outright to the younger generation. When determining the fair market value of a limited partnership interest, it is common to take into account both lack-of-marketability and minority discounts of 15% to 45%. For example, rather than transferring $1.8 million in wealth to the next generation, through the creation of an FLP a parent could potentially reduce the gift to $1 million for tax purposes.
While the gift and estate tax benefits of an FLP are compelling, the FLP is not without disadvantages.
- It adds complexity and cost to the estate plan. Hard-to-value assets will need a professional appraisal at the time each partnership unit is transferred from one generation to the next.
- While the parents can manage the FLP, they cannot treat the partnership’s assets as if they still belong to them.
- The general partner retains unlimited liability. (In some states, the creation of a family LLC provides the advantages of an FLP without the liability exposure.)
- It increases the probability of an IRS audit.
Recently, there has been a flurry of challenged estate tax returns involving FLPs. An examination of recent court cases provides a road map for how not to use FLPs.
Abraham: Good Intentions Awry
This is a case where the family limited partnership was doomed by good intentions. One of the time-honored rules of estate planning is that a gift must be complete to be effective. Except in limited instances, if the donor continues to enjoy the fruits of the gift, it has not been removed from her estate. In this case, the Abraham family created the FLP to provide for the guaranteed support of the matriarch, Ida Abraham.
Ida Abraham inherited three pieces of commercial real estate from her husband. In 1993, she was diagnosed with Alzheimer’s and her daughter was appointed her guardian. Her other three children sued their sibling over the amount needed to care for Mrs. Abraham. The cost of litigation became so draining that the probate court stepped in and required that an estate plan be put into place to meet her needs.
The plan included three FLPs, each funded by a piece of commercial real estate. Mrs. Abraham became both a general and a limited partner in each FLP; however, due to her incompetency, an attorney was appointed her guardian ad litem to manage her interest in the partnerships. Her guardian was also the sole shareholder of the corporation that acted as a managing general partner. Three of her four children purchased limited partnership units in the respective
FLPs for nominal sums of money. They also received gifts of limited partnership units annually.
In approving this estate plan, the probate court decreed that Mrs. Abraham would never want for money, even if the shortfall had to come from the children’s partnership shares. While the partnership agreements did not require the partnership to support Mrs. Abraham, it was understood by all that the FLPs would guarantee protection of her status quo.
A few years later, Mrs. Abraham died and the IRS challenged the estate tax return. Unwittingly, the children’s own testimony about the purpose of the FLP sealed the IRS’s case against the estate.
The tax court found that there was no bona fide sale of FLP interests between Mrs. Abraham and the children because there was no attempt to substantiate the fair market value of the units and the applied discounts at the time of the transfer. The court also found that there was an implied agreement between Mrs. Abraham, her guardian ad litem, and her children that the FLPs were obligated to support Mrs. Abraham, even to the detriment of the other partners.
Mrs. Abraham’s estate was assessed $939,195 in additional estate taxes. (Estate of Ida Abraham et al. v. Commissioner; No. 04-1886; Abraham v. Commissioner, T.C. Memo 2004-39; February 18, 2004)
Korby: Only to Avoid Taxes